LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

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Compensation and the Consequences of Preemption

Executive compensation has typically fallen within the realm of fiduciary duties; matters typically determined under state (read Delaware) law.  But state law has not proved up to the task.  As a result, both SOX and Dodd-Frank have increasingly federalized the compensation process.  Say-on-pay is the most obvious recent example.  The trend is likely to continue. 

Moving matters to the federal level has a number of significant consequences.  One of them is that policy is determined by Congress or the Executive Branch, both of which must contend with interest groups that go beyond shareholders and managers.  An example occurred in connection with GM, Ally and AIG, three companies where the government still has a sizeable investment.

According to the WSJ, Treasury reported that "[o]verall pay" at these three companies will remain "frozen."  Moreover, the CEOs of the three companies "didn't request pay increases."  As Acting Special Master for Treasury put it:

The overall CEO compensation packages payable by AIG, Ally Financial and GM have not increased.  Although there has been some modification in the mix of stock salary and long-term restricted stock for the CEO group, the overall amount of CEO compensation is frozen at 2011 levels. 

The approach likely forestalls public criticism of the government.  But is it the right decision?  GM, for example, had a good (great) year.  As the WSJ reported:

The Detroit auto maker earned $7.59 billion in 2011, a 62% increase from the prior year, and the biggest profit in its 103-year history on the strength of its once-unprofitable North American business. Sales in its two biggest markets, China and the U.S., continue to expand. Chinese volume rose 12% and the U.S. 11%, both in March.

Indeed, GM has argued the pay restrictions may cause competitive disadvantage.  "The pay restrictions make our jobs a lot harder when it comes to recruiting and retaining the best talent in the business," GM spokesman Jim Cain said on Friday.

The point is not to criticize Treasury.  Given the political constraints, the matter looked well handled.  But it is a consequence of pushing compensation matters to the federal level and may be a harbinger of things to come. 

What would prevent this from continuing?  A tougher standard applied to compensation decisions at state law, as one Vice Chancellor mentioned.  If states were tougher on the issue, there would be less pressure to federalize the matter.  But this long term view is unlikely to be adopted.  Federalization will, as a result, continue. 


The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Part 4)

Stephen Bainbridge was kind enough to respond to my post from last week, wherein I noted that in my most recent paper I had aligned his director-primacy theory with real entity theory rather than aggregate theory.  (You can find my paper here, my post from last week here, and Bainbridge’s reply here.)  As expected, he disagreed with my approach and I’d like to summarize his response and make some additional comments.

Basically, Bainbridge reaffirms that he grounds director-primacy squarely within aggregate / contractarian theory.  To the extent that there is some rhetoric attributable to him that suggests an openness to entity theory, it is better understood as distinguishing the theory of connected contracts.  Thus, the following passage from Bainbridge’s “The Board of Directors as Nexus of Contracts” is best understood as acknowledging that there is indeed something more to the corporation than individuals contracting directly with one another, and that this something more is properly understood to be the board of directors serving as a nexus for contracting—but this is not the same thing as saying that the corporation itself is some independent real or artificial entity.

To be sure, the traditional insistence that the firm is a real entity tends towards mindless formalism.  Yet, perhaps some deference should be shown the corporation’s status as a legal person. Corporate constituents contract not with each other, but with the corporation. A bond indenture thus is a contract between the corporation and its creditors, an employment agreement is a contract between the corporation and its workers, and a collective bargaining agreement is a contract between the corporation and the union representing its workers.  If the contract is breached on the corporate side, it will be the entity that is sued in most cases, rather than the individuals who decided not to perform. If the entity loses, damages typically will be paid out of its assets and earnings rather than out of those individuals’ pockets. To dismiss all of this as mere reification ignores the axiom that ideas have consequences.

Next, Bainbridge points out that while certain aspects of real entity theory overlap with aspects of director-primacy theory (they both, as Avi-Yonah puts it in describing real entity theory (here), shield management “from undue interference from both shareholders and the state”), this is not enough to tear director-primacy away from contractarianism.  As Bainbridge notes: “Just because two roads end up in the same place, doesn't mean that they are one and the same.”  Rather, director-primacy is best situated within contractarianism because its primary attributes of power-of-fiat and the protections of the business judgment rule exist because they “are majoritarian defaults provided by the law to facilitate private ordering. Not because the corporation is an entity.”

Finally, Bainbridge equates any theory that requires him to “think of the corporation as an entity--real or otherwise--rather than as an aggregate” with “metaphysical mumbo jumbo” and “transcendental nonsense.”  Writes Bainbridge: “I just can't wrap my head around the metaphysical abstractions.”

By way of response, let me start at the end by saying that I may have just as much trouble with any theory that requires me to think of corporations as nothing more than an association of individuals.  Bring together any group of random individuals you like and they can desire with all their might to incorporate, but without the assistance of the state they will be left a general partnership.  One might respond to this by saying that what the state asks of them in order to incorporate is not much, but as Grant Hayden and Matthew Bodie have put it (here): “One cannot contract to form a corporation…. The fact that th[e] permission [to incorporate] is readily granted … does not change the fact that permission is required.”  I might go so far as to say that any theory that requires me to ignore all the things that make some international conglomerates more powerful than small nations on the basis of the mantra that they are mere “associations of citizens” is likewise asking me to engage in metaphysical mumbo jumbo and transcendental nonsense.

If one understands “aggregate” theory, “real entity” theory, and “artificial entity” theory to effectively be terms of art that, among other things, try to describe a rational theoretical basis for deciding how much deference to give the state in terms of regulating corporations (and for what ends), then the fact that there is no physical entity associated with the corporation should not preclude finding real or artificial entity theory to be useful.  Furthermore, if one takes seriously the distinction between nexus-of-contracts theory in general and director-primacy theory in particular, and if one further takes seriously the need to align corporate and constitutional theories of the corporation, then making room for both contractarianism and director-primacy, along with aggregate and real entity theory, seems at least defensible in light of the overlap between the theories mentioned above.  As J.W. Verret has put it in differentiating contractarianism from director-primacy (here):

The contractarian model is in many ways a precursor to two subsequent corporate theories, the shareholder primacy model and the director primacy model. Both of those offshoots of the contractarian approach accept shareholder wealth maximization as the determining factor in designing default rules to govern the corporate enterprise, but they differ as to the appropriate allocation of power between shareholders and corporate directors.

Having said all that, I certainly don’t want to get overly distracted from my primary goal in writing the paper, which is to encourage the Supreme Court to discuss corporate theory expressly (and I believe this is an area where Bainbridge and I are in agreement).  As I have said previously, arguments about where to locate director-primacy vis-à-vis constitutional theories of the corporation may ultimately have little impact on that agenda.  At the same time, I certainly don’t want to advocate an indefensible position.  While I am willing to concede this debate if necessary, to this point I’m still comfortable that at the very least I have a colorable claim to make regarding director-primacy as real entity theory.  As for my own lingering questions about whether the business judgment rule and board power-of-fiat are best understood as “majoritarian defaults provided by the law to facilitate private ordering”—I’m leaving that for my next project, tentatively entitled “Rehabilitating Concession Theory” (go here for the ironic title inspiration).


The JOBS Act and the Capital Raising Process (Implementation Begins)

Some provisions of the JOBS Act require Commission rulemaking before implementation can occur.  Some, however, do not.  The Commission has already announced that the system of "secret" review of draft registration statements will begin. 

Pursuant to the Jumpstart Our Business Startups Act, an Emerging Growth Company (as defined in the Act) whose common equity securities have not been previously sold pursuant to an effective registration statement under the Securities Act of 1933 may confidentially submit to the Commission a draft registration statement for confidential nonpublic review. Until we fully implement a system that provides for electronic transmission and receipt of confidential submissions, we ask that you submit draft registration statements in a text searchable PDF file on a CD/DVD. Alternatively, you may submit them in paper, and if you do, we ask that you not staple or bind them. Please include a transmittal letter in which the company confirms its Emerging Growth Company status.

This is not the only example of non-public review of filings that do not appear electronically on EDGAR.  See Exchange Act Release No. 45922 (May 14, 2002) ("The Division of Corporation Finance ("Division") currently permits first-time foreign registrants, upon request, to submit paper drafts of their initial Securities Act or Exchange Act registration statements for staff review on a non-public basis.").   


The JOBS Act and the Capital Raising Process (The SEC Budget)

In signing the JOBS Act, the President made clear that the SEC was given sufficent resources to police the new requirements and protect investors.

  • It also means that, to all the members of Congress who are here today, I want to say publicly before I sign this bill, it's going to be important that we continue to make sure that the SEC is properly funded, just like all our other regulatory agencies, so that they can do the job and make sure that our investors get adequate protections.

The new legislation, therefore, provides a basis for adequately funding the agency, something that has been a struggle in recent years.  The adoption of the JOBS Act reflected bipartesanship in Congress.  ONe hopes that SEC funding will get the same kind of support.


The JOBS Act and the Capital Raising Process (Crowdfunding and the Computation of Net Worth)

We noted that the crowdfunding exemption is premised around reduced protections for investors, but restrictions on the amount they can invest.  The idea is that crowdfunding is not unlike gambling, but the stakes allowed to be wager are low.

This is simply not true.  The test for investment limits looks to income and net worth.  If below $100,000, the amount that can be invested is the greater of $2,000 or 5%.  If above $100,000, the amount is 10%. The key is net worth.  The JOBS Act provides that net worth is to be calculated in the same fashion as the test for accredited investors (accredited investors are those with a net worth of $1 million or more). 

The term net worth is not defined in Regulation D.  The SEC has merely characterized it as the difference between assets and liabilities.  See Securities Act Release No. 9177 (Jan. 25, 2011) ("Neither the Securities Act nor our rules promulgated under the Securities Act define the term 'net worth.' The conventional or commonly understood meaning of the term is the difference between the value of a person's assets and the value of the person's liabilities."). 

Moreover, the SEC has indicated that no assets are excluded from the calculation.  See Securities Act Release No. 6455 (March 3, 1983) ("Rule 501(a)(6) does not exclude any of the purchaser's assets from the net worth needed to qualify as an accredited investor.").  Indeed, the Commission adopted a higher net worth threshold in Regulation D in order to avoid having to decide what assets, if any, should be excluded from the calculation.  See Securities Act Release No.  6389 (March 8, 1982) ("Some commentators, however, recommended excluding certain assets such as principal residences and automobiles from the computation of net worth. For simplicity, the Commission has determined that it is appropriate to increase the level to $1,000,000 without exclusions."). 

This lack of any exclusion was modified by Congress in Dodd-Frank.  Congress required the Commission to exclude from net assets the value of the primary residence.  This has been done.  See Rule 501(a)(5) of Regulation D.  But that is it.  No other assets are explicitly excluded.  

All of this suggests that in calculating net worth, individual investors are allowed to consider assets in retirement accounts.  We have not found any explicit pronouncements on this issue by the Commission.  Nonetheless, there are other instances where parties included retirement accounts in the net worth calculation without controversy.  See In re Desano, Initial Decisions Release No. 412 (admin proc.  Jan. 18, 2011) ("Burns, representing that he has been unemployed for almost six years and has a net worth of $260,000, including retirement accounts and the blue book value of his car, claims an inability to pay, but has not provided a sworn financial statement."); see also In re Prime Capital Services, Inc., Exchange Act Release No. 61719 (admin proc March 16, 2010) ("In 2004 and 2005, Representative Wells induced a 71-year-old woman to liquidate her retirement account and invest all of her retirement savings -- which was more than half her net worth -- in variable annuities.").  

This suggests that individuals with very modest income levels will be able to nonetheless invest in crowdfunding ventures sums equal to 10% of their net worth, including retirement plans.  Thus, an individual with $300,000 in an IRA and an income of $30,000 will be allowed to invest his or her entire income (10% of net worth or $30,000) in a crowdfunding venture. Moreover, for those engaging in fraudulent deals will have an incentive to focus on retirees who have a modest amount tucked away in retirement accounts in order to take advantage of the net worth forumula.

Whatever the theory of crowdfunding, the amount allowed to be gambled can be significant.  If this were Las Vegas, it would be necessary to move crowdfunding to the high stakes part of the casino.  


The JOBS Act and the Capital Raising Process (General Solicitations, Rule 506, and the Missed Opportunity)

The JOBS Act also required that the Commission amend Regulation D (specifically Rule 502(c)) to provide that the prohibition on general solicitations will not apply to offerings under Rule 506 "provided that all purchasers of the securities are accredited investors."  The exemption shall, however, "require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors."

Of all of the provisions in the JOBS Act designed to promote capital raising, this one has the most potential for success.  Allowing companies to broadly advertise private placements may help locate a larger class of potential investors.  Yet the provision as drafted will be likely not be effective in that regard.

First, the provision oddly is keyed to Rule 506, rather than the statute.  Rule 506 is a safe harbor under Section 4(2), the private placement exemption.  Section 4(2) is used in cases where companies sell to a small number of sophisticated investors or as a backup in case the requirements of Rule 506 are not met.  By allowing general solicitations only for offerings under Rule 506, the exemption in Section 4(2) will become less appealing.  In effect, the cost of obtaining a pass on general solicitations will be the need to adhere to a a higher cost regulatory environment (Rule 506).  So the net result may be more rather than less regulation of a private placement offering.   

Second, the risk of liability associated with the use of the exemption is significantly greater than many other exemptions.  The ability to use a general solicitation is determined not at the time of the solicitation, but at the time the purchases are made.  To the extent a company engages in a general solicitation but sells to unaccredited investors, the exemption under 506 will be unavailable.  Because the fallback, Section 4(2) does not permit a general solicitation, the inapplicability of the exemption will result in a violation of Section 5.   

Third, the JOBS Act also requires companies to "take reasonable steps to verify that purchasers of the securities are accredited investors."  This imposes affirmative obligations on the part of the company using the exemption to ensure the accredited status of the investors.  Moreover, the statute does not state that companies taking these "reasonable steps" will be free from liability should an unaccredited investor actually purchase shares.  In other words, as currently phrased, the requirement that companies take "reasonable steps" is simply another requirement of the statute that, if not done, can result in the unavailability of the exemption.  In those circumstances, the sale to a single unaccredited investor may still result in the unavailability of the exemption.   

Its possible (although the statute does not say it) that Congress intended to allow the use of the exemption where unaccredited investors purchases shares so long as the company took the requisite reasonable steps.  Nonetheless, there will likely be instances where the purchase by an unaccredited investor was deemed "unreasonable" and, as a result of this single investor, the exemption will not be available. 

Fourth, general solicitations may not result in a violation of Section 5 but they can still result in a violation of the antifraud provisions.  Trying to attract investors with a positive message may subsequently be viewed as materially incomplete.  Moreover, to the extent the company is public, the general solicitation will likely be information ultimately conveyed to the market.  The action for fraud would be brought on behalf of all shareholders, not just those who purchased in the private placement. 

It is likely, therefore, that most legitimate issuers will not use the general solicitation authority included in the JOBS Act.  Those promoting fraudulent deals will, however, have no such hesitancy.  Pump-and-dumps and other fraudulent transactions require general solicitations as a mechanism for encouraging investor demand.  Once demand increases, promoters typically sell large blocks of stock into the market.  Eventually, the price collapses but the perpetrator of the fraud has cashed in.  These often occur through spam email. See Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions

Until the JOBS Act, only those purporting to rely on Rule 504 could use general solicitations (the "seed capital" rule permits general solicitations in some circumstances).  The rule had a cap of $1 million and was limited to non-reporting companies.  See Rule 504(a) of Regulation D.  With the JOBS Act, general solicitations relying on Rule 506 can be for unlimited amounts and be used by reporting companies.  Since the validity of a general solicitation under this Rule is determined not at the time of the solicitation, but at the time the shares are purchases, the SEC will have less room to close down a fraudulent deal.  Said another way, the SEC will have to wait until investors have actually been injured before being able to intervene. 

One way to reduce this possibility is to ban recidivists from using Rule 506.  Proposals to do so (as mandated by Dodd Frank) are in the works.  See Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.  Yet the current proposals do not cover all of the participants involved in schemes designed to circumvent the registration requirements. 

Another possibility would have been to allow for certain types of general solicitations.  Prohibiting the use of spam email, for example, would not be likely to harm legitimate businesses, but would probably make it harder for those committing fraud.  Nonetheless, such a refinement does not appear in the JOBS Act.  


The JOBS Act and the Capital Raising Process (Adding Confusion and Cost under Section 12(g))

The JOBS Act will not universally facilitate capital raising.  It imposes categorical rules that will raise costs.  An example is Section 501.

This provision raises the threshold for companies becoming public under Section 12(g) of the Exchange Act.  Added in 1964 to require companies in the OTC to file periodic reports, the provision required registration with the Commission (and the filing of periodic reports) of any company with $1 million in assets and 500 shareholders "of record."  The former was raised to $10 million by rule, but the 500 shareholders of record requirement remained unchanged (although slightly modifed by the SEC to include brokers and banks with shares in a depository). 

The problem with the threshold was not that it was too low, but that it looked to record owners rather than beneficial or street name owners.  A company could have thousands of beneficial owners but less than 500 shareholders "of record."  As a result, the threshold had no meaningful relationship to the actual number of investors in the company.

A legislative fix, therefore, was arguably necessary.  The fix by Congress, however, did not address the central problem, but instead added costs and complications to the process.  Section 501 reaffirmed the "of record" standard while raising the number from 500 to 2000.  Because companies already had the ability to have 2000 street name investors while keeping the number of "of record" owners below 500, this change was not likely to have much effect.  But Congress went one step further and added a provision providing that companies would be required to register under Section 12(g) if they had more than "500 persons who are not accredited investors (as such term is defined by the Commission)."

This provision will require private companies to monitor the number of shareholders of record.  That does not reflect a change.  In addition, however, they will have to monitor whether shareholders "of record" are accredited or unaccredited. That means that non-public companies will have to ask transfer agents to maintain records on the type of shareholder owning shares.  This will no doubt add to the fees charged by transfer agents. 

This may slow the transfer process and require additional paperwork whenever shares are sold.  Once shares have become freely transferable, however, determining the nature of the investor will almost be impossible.  With trades taking place in the secondary market, there will be no way to monitor the accredited/unaccredited status of investors.  Perhaps companies or their transfer agents can contact shareholders "of record" after they have acquired the shares but in addition to the costs of doing so, shareholders may not respond.

Moreover, it is not unusual for private companies to have some freely transferable shares.  Shares can become freely transferable either as a result of a registered offering (perhaps by a company that at the time had less than $10 million in assets) or as a result of the removal of restrictions on an exempt sale  (perhaps under Rule 144).  Where the accredited/unaccredited status cannot be verified, companies will in effect have to treat all purchasers as unaccredited.  In effect, therefore, Congress as all but reinstated the 500 shareholders of record standard under Section 12(g). 

But it is even more complicated than that.  The JOBS Act provided that "held of record" does not include "securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of section 5 of the Securities Act of 1933.’’  Section 503 gives the SEC the authority to "adopt safe harbor provisions that issuers can follow when determining whether holders of their securities received the securities pursuant to an employee compensation plan in transactions that were exempt from the registration requirements of section 5 of the Securities Act of 1933."

The provision is not entirely clear but it seems to apply only to the employees who acquired the shares under the requisite compensation plan ("persons who received the securities"), not those who bought them from the employees.  So companies can exclude from the 2000/500 unacredited threshold employee shareholders, but once the employees sell the shares companies must include any new owner holding shares "of record" in the 2000/500 thresholds.   

All of this means that private companies will find the record keeping requirements associated with share ownership becoming more complicated and will find themselves paying more to transfer agents.  Moreover, these complications will not apply only to private companies close to the 2000/500 thresholds.  Any private company that may become public in the future will need to maintain the records and pay the additional costs.   


The JOBS Act and the Capital Raising Process (The On Ramp and the Secret Review Process)

The On Ramp provisions exempt "emerging growth companies" from certain requirements of the securities law.  In addition, these companies are entitled to special access to the staff of the Commission.  Specifically, Section 106 of the JOBS Act added a provision that provides: 

(e) EMERGING GROWTH COMPANIES.—  (1)  IN  GENERAL.—Any emerging growth company, prior to its initial public offering date, may confidentially submit to the Commission a draft registration statement, for confidential nonpublic review by the staff of the Commission prior to public filing, provided that the initial confidential submission and all amendments thereto shall be publicly filed with the Commission not later than 21 days before the date on which the issuer conducts a road show, as such term is defined in section 230.433(h)(4) of title 17, Code of Federal Regulations, or any successor thereto.

Section 6(e) of the Securities Act of 1933, 15 USC 77f(e). In other words, companies considering an IPO can have a "secret" review of the registration statement by the staff of the Commission.  The information will also be exempt from disclosure under the FOIA. 

Companies that "secretly" file draft registration statements will not generally be able to keep the fact secret.  They may announce the filing or it may leak to the public.  Secret or not, the company will presumably have to go into the quiet period.  As a result, anyone watching the company will likely know that a registration statement has been filed since the company's approach to public communications will change.

Concern has also arisen that the "secret" review process will delay the market's awareness of problems raised with a registration statement.  During the registration process, Groupon had a number of "well-publicized disagreements with the SEC over its accounting."  Critics, according to the WSJ, have asserted that the JOBS Act, had it been in place, would have allowed the disagreements to be resolved "under the radar, without investors learning of them until later although still before any IPO." 

The benefits of this system of "secret" review may ultimately prove illusory.  First, without the pressure of a public filing, the staff of the Commission may take its time in commenting on draft registration statements, adding delay to the process.  Moreover, without the pressure from the public to have the IPO go forward, the staff may prove more intransient with respect to issues raised in the comment process.  

With the benefits questionable, the harm is not.  The provision will ultimately reduce the time that the market has to assess an IPO.  To the extent that all issues have been resolved with the staff during this "secret" process, the company may be able to go effective very quickly after the public filing of a registration statement.  There will be less time for the public to identify issues that might become part of the SEC review process or to publicize concerns that help ensure informed decision making.


The JOBS Act and the Capital Raising Process (The Permanent On Ramp)

The JOBS Act creates a new class of companies,"emerging growth companies," and exempts them from a host of regulatory requirements.  An emerging growth company is defined as "an issuer that had total annual gross revenues of less than $1,000,000,000 . . . during its most recently completed fiscal year." 

The idea behind the provision appears to be that a company will be more willing to go public because the regulatory consequences of doing so will be reduced.  Once, however, the company grows to a certain size (over $1 billion or becomes a large accelerated filer) or issues a certain amount of debt ($1 billion in non-convertible debt over a three year period), it will lose its status as an emerging growth company and thereafter be required to conform to all of the requirements of the securities laws.

Growth in the business, of course, cannot be predicted with any certainty, but at least some of the emerging growth companies will permanently stay below the requisite thresholds.  Nor will they achieve the requisite size to meet the definition of large accelerated filer or issue the requisite amount of debt.  As a result, the only way in those circumstances to cease to be an "emerging growth company" is to do an equity offering and wait five years.  Indeed, the status will be lost on the fifth anniversary after "the date of the first sale of common equity securities of the issuer pursuant to an effective registration statement."

The provision, therefore, contemplates that a company will go public by way of an IPO and get a pass for no more than five years.  But what if a company becomes public but never does an equity offering?  Under Section 12(g), companies are subject to the securities laws (including the periodic reporting requirements) whenever they have more than $10 million in assets and, after the JOBS Act, 2000 shareholders of record (or 500 unaccredited investors).   In other words, they can be required to file periodic reports and a public market can develop in their shares without ever having undertaken an equity offering.  Indeed, it is not uncommon for companies to register under Section 12(g) voluntarily (for example to qualify for trading in the OTC Bulletin Board) without even meeting the asset/shareholder of record test in the statute. 

Likewise, the statute does not apply to companies that sold equity shares pursuant to "an effective registration statement under the Securities Act of 1933" on or prior to December 8, 2011.  This suggests that only companies going public after that date will qualify as an emerging growth company.  But in fact, any company that is public and under $1 billion will qualify so long as it has not done an equity offering. 

To the extent that companies become public other than through the filing of a registration statement, they can remain an emerging growth company indefinitely.  Of course, the time period is triggered not by an IPO, but any offering of equity "pursuant to an effective registration statement".  Thus, the period will begin to run when an offering is registered on behalf of employees or selling shareholders. 

Nonetheless, companies that refrain from equity offerings can retain the status of "emerging" growth company indefinitely.  This, of course, may prove very confusing to investors since similarly situated companies may be subject to very different regulatory regimes.   


The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Part 3)

I’m continuing my online article workshop on my latest project, “The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases” (abstract and draft available here). Certainly, this continues to be timely as Citizens United is once again in the news—this week being cited by one commentator (here) as part of a line of cases—soon to be extended (at least in the author’s view) by the Court’s ruling on “Obamacare”—that demonstrate that the current Supreme Court “sees no limits on its power [and] no need to defer to those elected to make our laws.”

The aspect of my paper that I want to discuss this week is my assertion that the director primacy theory of the corporation is better aligned with real entity theory rather than the aggregate theory of the corporation—at least for the purposes of my paper.  For the uninitiated, the aggregate theory of the corporation posits that the corporation is best understood as primarily an association of individuals.  This is to be contrasted with artificial entity theory, which views the corporation as much more than simply an association of individuals—and traces that “much more” to advantages flowing from the state.  Real entity theory, meanwhile, argues that the corporation should be understood as something independent of both the individuals that make it up and the state that created it.  The relevant consequences of all of this is that artificial entity theory tends to be quite deferential to state regulation, while aggregate and real entity theory tend to favor private ordering.  Aggregate theory is then distinguishable from real entity theory on the basis of what the private ordering in each case is primarily understood to serve: in the case of aggregate theory it is the shareholder, while in the case of real entity theory there is more discretion to serve a variety of stakeholder interests.  (It should go without saying that scholars are not universally united on these formulations.)  Finally, because corporate law theorists tend to use different terminology, it is necessary to correlate those terms with the foregoing.  Thus, corporate law’s concession theory is typically aligned with artificial entity theory, while contractarianism (the nexus-of-contract theory of the corporation) is typically aligned with aggregate theory.  But what about director primacy, which posits that “the corporation is a vehicle by which the board of directors hires various factors of production. Hence, the board of directors is not a mere agent of the shareholders … but rather is a sui generis body—a sort of Platonic guardian” (Stephen Bainbridge, “The Board of Directors as Nexus of Contracts”)?

My greatest obstacle in aligning director primacy theory with real entity theory is likely that Stephen Bainbridge, the leading proponent of the theory whom I quote above, disagrees. However, even Bainbridge has arguably acknowledged that there may be some limited role for viewing director primacy as an expression of real entity theory: “[T]o the limited extent to which the corporation is properly understood as a real entity, it is the board of directors that personifies the corporate entity” (quote from here).

One reason why it may be correct for me to align director primacy theory with real entity theory for the limited purposes of my paper, is that director primacy theory may properly be understood to be a version of contractarianism.  For example, I note in my paper that J.W. Verret has written that: “The contractarian model is in many ways a precursor to … the director primacy model” (quote from here). If that is correct, and if it is further correct to align contractarianism with aggregate theory, then I should arguably either ignore director primacy or locate it elsewhere.  Because director primacy theory at the very least has a lot in common with some versions of real entity theory, it seems better to locate it there than ignore it.  For example, real entity theory has been described by Reuven Avi-Yonah as the theory which “represents the most congenial view to corporate management, because it shields management from undue interference from both shareholders and the state” (quote from here). That seems quite consistent with director primacy. 

There’s obviously much more to say on this, but I think I’ll stop there for the time being.  Before I close, however, I want to note the reason I believe all of this matters.  I am arguing in my paper that the conclusions of the justices in Citizens United (and the main cases leading up to Citizens United) were driven in large part by what theory of the corporation they aligned themselves with.  Yet they either ignored or expressly disavowed any role for corporate theory.  I believe that this is an omission and inconsistency that negatively implicates the transparency and legitimacy of the Court, and my paper is intended to advance the ball on getting the justices to directly address the issue of corporate theory in these types of cases.  Thus, for the time being it may not matter as much how we align the various theories, so long as we are talking about them. 


The "JOBS" Act and the Capital Raising Process (Crowdfunding and the Costs of the Exemption)

Issuers seeking to use the crowdfunding exemption will discover that it is cumbersome and expensive.  As a result, many legitimate companies will likely shy away from it.  Less legitimate companies will have no such qualms. 

First, the idea is that issuers will need to use a portal (or broker) to effectively advertise the offerings.  Presumably, issuers will need to pay portals for the service.  Perhaps the fee will be up front; perhaps it will be a percentage of the amount of capital raised.  To the extent the former, issuers will have to take the risk that they will raise sufficient capital to compensate for the costs.

Second, success for issuers will often depend on the ability to promote their offering.  Yet the provision prohibits general solicitations by issuers (except to the extent they merely refer investors to the relevant portal).  See Section 4A(b) (issuers may "not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker"). 

On the other hand, third parties can promote the offering and will be allowed to charge for this service (although they must use communication channels provided by the portal), subject only to the limitation that the financial arrangement be disclosed.  See Section 4A(b) (issuers may "not compensate or commit to compensate, directly or indirectly, any person to promote its offerings through communication channels provided by a broker or funding portal, without taking such steps as the Commission shall, by rule, require to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication").  All of this will add expense. 

Third, issuers seeking to raise the maximum amount permitted under the exemption will find that they need an independent accountant.  Those with a capital raising target of more than $500,000 must have audited financial statements. 

Fourth, companies will incur costs arising out of the shareholder configuration resulting from the crowdfunding exemption.  All companies must have an annual meeting of shareholders.  Shareholder with voting rights need to be notified of the meeting.  Companies will, therefore, have to provide a notice every year to these shareholders. 

Fifth, the crowdfunding exemption imposes a requirement that companies keep investors informed even after they purchase the shares.  The provision requires companies to file reports with the Commission at least annually and provide the reports to investors.  The reports must contain "the results of operations and financial statements of the issuer, as the Commission shall, by rule, determine appropriate, subject to such exceptions and termination dates as the Commission may establish, by rule". 

Sixth, because investors purchasing pursuant to the exemption do not count as shareholders "of record" for purposes of Section 12(g), the company will need to maintain more intricate shareholder ownership records.  They will need to know which shares were acquired through the crowdfunding exemption (and therefore not "of record") and which ones were not. 

Seventh, while these shares will be difficult to sell (in many cases there will be no meaningful secondary market), the company is likely to incur increased expenses associated with the transfer of shares.  Companies must maintain a list of record owners.  In many cases, this entails the issuance of a stock certificate.  When a sale occurs, the certificate must be canceled and a new one issued.  Companies using the crowdfunding exemption will likely see an increase in transfers.  Either the company must do the paperwork (and pay an employee to do it) or hire a transfer agent (or perhaps increase the fees to the transfer agent).  Either way, the companies will incur increased costs associated with servicing the additional shareholders.

Finally, in addition to costs, issuers, their directors and executive officers will need to go through a background check.  It may not add expense but it is intrusive.  

Given these costs and restrictions, one has to wonder why an issuer wouldn't just rely on Rule 506 of Regulation D, particularly now that general solicitations are permitted in offerings limited to accredited investors.  Moreover, the issuer itself can conduct the general solicitation, without having to pay a portal for the same service.


The JOBS Act and the Capital Raising Process (Crowdfunding and Concerns with the After Market)

A central problem with crowdfunding is the absence of any meaningful exit strategy once the shares are purchased.  Shares must be restricted.  Investors will need to wait a year before selling unless they sell to accredited investors, back to the company, in a registered offering, or to a family member. Presumably after a year, shareholders can get the restriction removed and sell them to anyone.  But if investors think that at the end of a year they will be able to sell, they will need to think again. 

A number of factors suggest that, in fact, it will be very difficult to sell shares purchased through the crowdfunding exemption. 

First, the exemption cannot be used by companies already public.  As a result, there will be no preexisting public market for the shares. 

Second, the large private companies intending to do a public offering will not use the exemption.  The amount that can be raised is too small.  Besides, companies thinking of going public probably have already obtained some venture capital financing.  For the most part, venture capitalists do not like the crowdfunding exemption, particularly the complex ownership structure that will result.  So crowdfunding investors will not have a public offering to look forward to as an exit strategy. 

Third, the most likely candidates for crowdfunding are those companies that intend to stay small and private.  Some may be listed in the pink sheets, but this will only occur if brokers can obtain the information required by Rule 15c2-11.  It is highly possible that many crowdfunding companies will not even be listed in the pink sheets. 

This will leave investors without the benefit of a trading market of any kind.  In those circumstances, it is possible that the investors may have to hold onto the shares indefinitely.  Nothing in the crowdfunding exemption addresses these problems except for the requirement that investors answer questions demonstrating that they have "(i) an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers; [and] (ii) an understanding of the risk of illiquidity".  

It is not clear that these "questions" will ensure that investors understand the problems of illiquidity in any meaningful way.  They may only realize the consequences when the time comes to write a tuition payment or pay off a car loan and discover that no one will buy their shares.   

What is the consequence of an indefinite holding period?

In addition to the possibility that shareholders may never be able to liquidate the investment (until the company liquidates, at which time there may or may note be funds around for distribution to shareholders), shareholders will be at risk as minority investors. Minority investors can see their interests diluted through the issuance of additional shares or the value of the company dissipated through the sale of assets. 

The crowdfunding exemption merely requires companies to provide a description "of the risks associated with minority ownership, corporate actions, including additional issuances of shares, a sale of the issuer or of assets of the issuer, or transactions with related parties." This is likely to result in boiler plate disclosure that will in some cases not be understood, in others ignored and, invariably, forgotten when the corporate action actually occurs. 

In some cases, these transactions may even be a result of deliberate design.  In other words, companies (and their controlling persons) may intend to raise the capital then engage in transactions designed to eliminate shareholder value.  Because these transactions will occur after the sale of shares, perhaps long after, it will be much harder for regulators or private parties to bring actions under the securities laws based upon false disclosure or registration violations. 

Some of the referenced transactions may require shareholder approval.  But it is not clear that shareholders will even receive voting shares.  In any event, as minority investors, they will have little actual say in the outcome. 

Investors relying on the crowdfunding exemption may be subjected to fraudulent transactions.  Even investors purchasing from legitimate companies, however, will incur the risk that they will have to hold the investment indefinitely.  They likewise will incur the risk that the company may engage in subsequent transactions that dilute the ownership interest and the value of the shares purchased. 

In short, for many investors, this will prove not to be a good use for any available funds. 


The "JOBS" Act and the Capital Raising Process (Crowdfunding and the Consequence of Gambling)

Crowdfunding embraces the notion that unaccredited investors with modest means should be allowed to invest in unregistered offerings.  The exemption, however, provides investors with little information about the company, often leaving them uninformed when they make the investment.  Some have likened the approach to gambling.  The saving grace was supposed to be that these investors could only invest a small amount of money and therefore wouldn't see their financial condition impaired in the event that the investment turned out to be fraudulent or quickly failed. 

But in fact, the crowdfunding exemption included in the JOBS Act is not limited to amounts that investors can afford to lose.  The provision allows those with an income or net worth of less than $100,000 to invest up to 5% of that amount or $5000 every year.  For those with a net worth or annual income above $100,000, they can invest up to 10% of that amount or up to $100,000 during any 12 month period.  The amounts will go up since the SEC is required to adjust them at least every 5 years in accordance with the Consumer Price Index.  See Section 4A(h) ("Dollar amounts in section 4(6) and subsection (b) of this section shall be adjusted by the Commission not less frequently than once every 5 years, by notice published in the Federal Register to reflect any change in the Consumer Price Index for All Urban Consumers published by the Bureau of Labor Statistics.").  In other words, investors over time will be allowed to invest annually more than $100,000.

Moreover, in computing income and net worth, the exemption contains no definition of the terms.  Instead, the exemption references the approach taken with respect to accredited investors.  Neither term is defined in Rule 501 of Regulation D.  Moreover, the SEC took a flexible approach with both terms, using high dollar thresholds for accredited investors as the primary mechanism for preventing abuse.  The same approach, however, does not work in the context of crowdfunding.   

While the term income is not defined, it was intended to apply to gross, rather than net, income.  As a result, the amount need not be reduced by the taxes paid or deductions taken.  See Securities Act Release No.  6389 (March 8, 1982) ("The test [for income] is no longer keyed to the federal income tax return. . . . Also, the term 'adjusted gross income' has been changed to 'income'. Use of the term 'income' will permit the inclusion of certain deductions and additional items of income which, as noted above, were excluded in the proposed concept of adjusted gross income.").  The term does not include for the most part unrealized capital appreciation but otherwise includes most if not all sources of income.  See Securities Act Release No. 6455 (March 3, 1983) (unrealized capital appreciation generally cannot be used in calculating income for purposes of the accredited investor standard). 

In other words, someone with $100,000 in gross income will be allowed to invest $10,000.  Yet the possibility that someone with a gross income of $100,000 can afford to lose $10,000 is small.  Moreover, the amounts used by investors of modest means to invest in crowdfunding ventures will probably result in other expenditures foregone.  Since rent, taxes, food, etc. cannot be eliminated, one has to wonder whether the amount invested in crowdfunding will result in a reduction in contributions to retirement plans.  Given the risks involved in crowdfunding (remember the analogy to gambling), swapping funds in this way will probably not be beneficial for investors of modest means in the long run.

But even those with income of far less than $100,000 will be eligible to invest $10,000 or more in crowdfunding ventures because the test turns not only on income but also on net worth.  Again, net worth is to be computed consistently with the approach used for accredited investors and again the term is not defined.  See Securities Act Release No. 9177 (Jan. 25, 2011) ("Neither the Securities Act nor our rules promulgated under the Securities Act define the term 'net worth.' The conventional or commonly understood meaning of the term is the difference between the value of a person's assets and the value of the person's liabilities.").  In adopting the net worth standard for accredited investors, the SEC allowed all assets to be included.  See Securities Act Release No. 6455 (March 3, 1983) ("Rule 501(a)(6) does not exclude any of the purchaser's assets from the net worth needed to qualify as an accredited investor."). 

In adopting a broad notion of net worth, the Commission deliberately decided not to take into account complicated issues surrounding the concept.  The Commission knew that this would allow investors to effectively overstate their real net worth but chose to address the concern through a high net worth amount.  See Securities Act Release No.  6389 (March 8, 1982) ("Some commentators, however, recommended excluding certain assets such as principal residences and automobiles from the computation of net worth. For simplicity, the Commission has determined that it is appropriate to increase the level to $1,000,000 without exclusions.").  

For persons with more modest means, however, this ability to "overstate" their net worth allows them to invest amounts that in fact they cannot genuinely afford to lose.  Thus, if they make $25,000 a year in gross income but have a net worth of $100,000, investors will be allowed to invest $10,000 in a crowdfunding venture.

How might someone with such modest income meet the $100,000 net worth standard?  They cannot use the appreciation in their principle residence.  Congress in Dodd Frank commanded that this amount be excluded from the calculation of net worth for accredited investors.  See Rule 501(a)(5) of Regulation D.  But as long as they borrow the equity appreciation (in the form of a second mortgage) more than 60 days before the purchase, they can count the loans as an asset.  Moreover, net worth can include their 401(k)/IRA, their car, their furniture, appreciation in property that is not a primary residence, and any other asset.  As a result, it will likely not be difficult for people with very modest means to have the ability to invest large amounts that they cannot afford to lose. 

In short, the dollar thresholds contained in the crowdfunding provision allow investors of very modest means to invest amounts that are beyond what they can afford to lose.  Moreover, the amounts invested may well result in a reduction in contributions to retirement plans, something that may have long term harmful consequences. 


The "JOBS" Act and the Capital Raising Process

As the House adopts the Senate version of the euphemistically titled "JOBS" Act (which is actually the House version, HR 3606, plus one significant Senate amendment on crowdfunding), the legislation continued the fast track to becoming law.  Pieces of the legislation have significant flaws.  Many investor groups have challenged all or portions of the law because of the lack of sufficient investor protections.  We will discuss some of those criticisms. 

In addition, however, the legislation does not do a particularly good job at encouraging capital formation.  We will discuss some of the capital raising weaknesses in the legislation in subsequent posts.  Thus, the law will weaken investor protections without necessarily delivering on the promised benefits of increased capital formation and job creation. 


Lawson v. FMR LLC: SOX Whistleblower Protection Does Not Extend to Employees of Private Contractors to Public Companies

In Lawson v. FMR LLC, No. 10-2240 (1st Cir., Feb. 3, 2012), a divided First Circuit reversed the district court’s denial of a motion to dismiss, holding that the whistleblower protection provision of the Sarbanes-Oxley Act of 2002 (“SOX”) does not cover employees of certain contractors or subcontractors retained by public companies.

Jackie Hosang Lawson and Jonathan M. Zang (“Plaintiffs”) were employees of FMR LLC and of other related private companies that served as investment advisers to the Fidelity family of mutual funds.  In 2005 and 2006, Plaintiffs filed SOX whistleblowing complaints.  See 18 U.S.C. § 1514A(b)(1)(A).  Zang alleged that he was discharged for reporting inaccuracies in a draft registration statement and Lawson alleged that she was discharged for raising concerns related to cost accounting methodologies.

SOX’s whistleblower protection provision states that no public company or “officer, employee, contractor, subcontractor, or agent…of such company” may “discriminate against an employee” for engaging in a protected activity.  18 U.S.C. § 1514A(a).  Plaintiffs argued that this protection extended to employees of any of the listed agents of that company, including contractors and subcontractors.  Defendants argued that the list of agents merely identified those who may not retaliate and was not intended to define the boundaries of those who were protected under the statute.

In interpreting the statute, the court found no evidence that Congress intended the list of agents barred from discriminating to also define those protected from discrimination. In contrast, both the title of SOX § 806 and the caption of § 1514A(a) provided guidance: both referred to “employees of publicly traded companies.” The court also examined similar statutory provisions in SOX and other acts, and found that Congress was explicit when extending broader whistleblower protection.  Finally, the legislative history of SOX specifically showed that the protection of § 1514A(a) was intended for employees of publicly traded companies.  

Finding that the protections of § 1514A(a) only extend to employees of publicly traded companies, and not to employees of private contractors or subcontractors to those companies, the court reversed and remanded to the district court with instructions to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.

A previous post on the district court decision may be found here.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (The Broader Significance of the Decision)(Part 6)

There are many things to like about this case. 

Plaintiffs alleged conflicts of interest. Defendants provided a rational for a finding that, at the pleading stage, these allegations did not raise any real concerns about the merger process.  The interest of the CEO of El Paso in buying the E&P business from Kinder Morgan could have been viewed as insignificant, a passing fancy.  The Chinese wall designed to keep Goldman from influencing the merger could have been viewed as adequate. Had the court agreed with these views, the case would have been addressed under the duty of care and quickly dismissed. The court, however, applied a mix of legal analysis and common sense to acknowledge that the allegations brought by plaintiffs in fact raised real concerns. 

The court also used a mix of legal analysis and common sense to conclude that an action for damages would not be sufficient.  Claims against directors would, at a minimum, flounder on the waiver of liability provision.  Claims against the CEO may have had a stronger legal foundation, but the court, in a common sense fashion, recognized that such an action would not provide an adequate amount of recovery even if plaintiffs were able to succeed.  

The court also recognized that, despite the payment of an adequate price for El Paso, shareholders may nonetheless have been harmed by this type of conflict. 

The kind of troubling behavior exemplified here can result in substantial wealth shifts from stockholders to insiders that are hard for the litigation system to police if stockholders continue to display a reluctance to ever turn down a premium-generating deal when that is presented. The negotiation process and deal dance present ample opportunities for insiders to forge deals that, while “good” for stockholders, are not “as good” as they could have been, and then to put the stockholders to a Hobson’s choice.

There are also some lessons from the case that in fact may improve the integrity of the process, providing greater assurance that the outcome will in fact be in the best interests of shareholders.  Certainly this case and others have sent a message to financial advisors that the Delaware courts will take a close look at their role in any merger, particularly those involving the possibility of a conflict of interest.  At a minimum, they will need to provide greater certainty that potential conflicts of interest play no role in the merger process. 

But in the end, there were no consequences for the potential problems identified by plaintiffs.  In other words, alleged conflicts of interest could be identified and harm shown but the courts would do nothing about them.

What about the argument that the injunction would have been harmful to shareholders?  There is, of course, the possibility that an injunction would have benefited shareholders by allowing the company to be sold at a higher price.  Likewise, the injunction could have caused Kinder Morgan to walk and take with it the highest possible price available to shareholders.  

The opinion, however, hinted at interest by both Kinder Morgan and other companies in acquiring the pipeline business.  Moreover, while the court was correct that there was no competing offer, El Paso was considering an alternative: spinning off the E&P business and allowing the pipeline to become a free standing business that was apparently of considerable interest to other companies.  It is possible that shareholders would have benefited from the alternative. 

All of this is, of course, speculation.  The truth is that any injunction would have posed the risk that shareholders would have lost out on the highest possible price.  Even if true, however, such an injunction would have produced benefits that went beyond the specific deal.  An injunction would have sent a warning in future mergers that the process mattered. 

Instead, the effect of this decision is to conclude that sometimes process matters and sometimes it does not, hardly a basis for shareholders placing their faith in process as a means of protecting their interest.   

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Part 2)

Last week I posted the abstract of my latest paper, The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (you can find the abstract and download the paper here).  I mentioned that I might engage in some “open source article writing,” since the paper is still subject to further revision and there are parts of it that I think would be of interest to our readers and that I’d love to get additional feedback on.  This week I’d like to focus on my argument that understanding Citizens United to be about the rights of listeners does not preclude finding an important role for corporate theory in the decision.  The following is from my introduction:

In Citizens United v. Federal Election Commission, a 5-4 majority of the Supreme Court ruled that corporate political speech could not be regulated on the basis of corporate status alone.   Given that there is a great deal of debate about what corporations are (they have to date eluded capture), one would think that the Court would have needed to answer that question first before reaching its conclusion.  However, the majority was silent on this issue and the dissent went so far as to expressly disavow any role for corporate theory at all.   Instead, the opinion appeared to rest on a “listeners’ rights” analysis.   It remains unclear, however, how focusing on listeners’ rights could eliminate all need to examine the nature of corporations.  For example, how would one know whether corporations fit within the well-established line of identity-based exception cases under the First Amendment without addressing the unique aspects of corporate identity?

The majority in Citizens United (at page 899 of the opinion) referenced the status-based exception cases as follows:

The Court has upheld a narrow class of speech restrictions that operate to the disadvantage of certain persons, but these rulings were based on an interest in allowing governmental entities to perform their functions. See, e.g., … Civil Service Comm'n v. Letter Carriers, 413 U.S. 548 (1973) …. The corporate independent expenditures at issue in this case, however, would not interfere with governmental functions, so these cases are inapposite.

The citation of the Letter Carriers case is of particular interest because after Citizens United it is apparently permissible under the First Amendment for the government to prohibit live human beings who happen to be federal employees “from taking ‘an active part in political management or in political campaigns,’” 413 U.S. at 595, 597 (Douglas, J., dissenting) (“We deal here with a First Amendment right to speak, to propose, to publish, to petition Government, to assemble.”), but the government may not similarly restrict the First Amendment rights of state-created artificial entities that have been granted unique attributes greatly amplifying their ability to concentrate wealth and thereby influence elections.

Justice Stevens’s response in dissent captures quite nicely why the question of what corporations are (and what sorts of threats they pose) remains relevant.  Justice Stevens notes (at 946, n.46) that:

The majority states that the [status-based exception cases] are “inapposite” because they “stand only for the proposition that there are certain governmental functions that cannot operate without some restrictions on particular kinds of speech.” The majority's creative suggestion that these cases stand only for that one proposition is quite implausible. In any event, the proposition lies at the heart of this case, as Congress and half the state legislatures have concluded, over many decades, that their core functions of administering elections and passing legislation cannot operate effectively without some narrow restrictions on corporate electioneering paid for by general treasury funds.

Thus, even putting aside for the moment the fact that listeners’ rights are not absolute as a general matter, the nature of the speaker remains relevant in any case because of the possibility that the speech of the particular class at issue implicates the protectable “interest in allowing governmental entities to perform their functions.”


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (Injunctive Relief)(Part 5)

With a finding that plaintiffs had sufficiently alleged "a reasonable likelihood of success in proving that the Merger was tainted by disloyalty" and a finding that an action for damages would be inadequate, the court considered whether an injunction was in order.   

Plaintiffs for the most part sought to enjoin not the merger agreement (although at oral argument they agreed they would accept this remedy), but sought what the court described as:

an odd mixture of mandatory injunctive relief whereby I affirmatively permit El Paso to shop itself in parts or in whole during the period between now and June 30, 2012, in contravention of the no-shop provision of the Merger Agreement, and allow El Paso to terminate the Merger Agreement on grounds not permitted by the Merger Agreement and without paying the termination fee. 

In other words, plaintiffs wanted the court to correct the faulty process.  Given the alleged conflicts of interest, shareholders wanted the court to allow for a process that would ensure that the company was sold for the highest possible price.

This, the court suggested, "would pose serious inequity to Kinder Morgan, which did not agree to be bound by such a bargain."  More importantly, the injunction would potentially cause "more harm than good" to shareholders by allowing Kinder Morgan to walk away from the offer.  "The injunction the plaintiffs posit would be one that would sanction El Paso in breaching many covenants in the Merger Agreement and that would bring about facts that would mean that El Paso could not satisfy the conditions required for Kinder Morgan to have an obligation to close."

The court also hinted that the efforts to shop the company were unlikely to succeed.

Although it is true that the absence of a pre-signing market check and the presence of strong deal protections may explain the absence of a competing bid, the reality is that this is a highprofile transaction, litigation has been pending since early autumn 2011, and no bidder has emerged indicating that it would bid for any part of El Paso absent the deal protections.

At the same time, by refusing to issue the injunction, shareholders would have an opportunity to collectively express their judgment on the transaction when they voted on the merger.  

Putting aside the expectations of Kinder Morgan, which is arguably stuck with the risk of having dealt with potentially faithless fiduciaries, the real question is whether the court should intervene when the El Paso stockholders have a chance to turn down the Merger at the ballot box.

As a result, as the court reasoned, "the record does not instill in me the confidence to deny, by grant of an injunction, El Paso’s stockholders from accepting a transaction that they may find desirable in current market conditions, despite the disturbing behavior that led to its final terms." So, there would be no relief for the alleged conflicts of interest.  As the court noted: "We all wish we could have it all ways. But that is not real life, nor is it equitable." 

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (The Damage Alternative) (Part 4)

Having found sufficient allegations of a conflict of interest, the court had to consider the remedy.  Plaintiffs sought an injunction. 

In a refreshing discussion, the court considered the alternative of a cause of action for damages but concluded that the claim was unlikely to succeed. 

Some claims were likely to fail because of legal impediments.  A claim for damages for breach of the duty of care against directors would fail both on the merits, see id. ("the independent directors’ reliance upon [the CEO] seems to have been made in good faith."), and because of the waiver of liability provision.  

Some claims might be inadequate for practical reasons.  The court suggested that any action against the CEO would not result in an adequate recovery. See id.  (wealth of CEO was unlikely to be sufficient to pay "a verdict of more than half a billion dollars."). 

An action against Goldman for aiding and abetting would also have little chance of success.  See id. ("And although Goldman has been named as an aider and abettor and it has substantial, some might say even government-insured, financial resources, it is difficult to prove an aiding and abetting claim."). 

The same was true of any possible claim against Kinder Morgan.  Id. ("Nor do I find any basis to conclude that Kinder Morgan is likely to be found culpable as an aider and abettor.").  

Thus, the court agreed that, "[f]or present purposes," the plaintiffs had "shown that there is a likelihood of irreparable injury if the Merger is not enjoined." 

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.


Delaware Courts and the Weakening of the Duty of Loyalty: In re El Paso Corp. Securities Litigation (The Alleged Conflicts) (Part 3)

Plaintiffs alleged two conflicts of interest.  One involved the role of Goldman Sachs, the other the role of the CEO of El Paso.

Goldman Sachs, the owner of 19% of shares of Kinder Morgan, had been been retained by El Paso in connection with the original plan to spin off the exploration and production (E&P) business.  With respect to the offer from Kinder Morgan, El Paso hired Morgan Stanley.  Goldman, however, remained the advisor on the proposed spin off and, allegedly, influenced the terms applicable to Morgan Stanley.  As the court found, Goldman:

continued to intervene and advise El Paso on strategic alternatives, and with its friends in El Paso management, was able to achieve a remarkable feat: giving the new investment bank an incentive to favor the Merger by making sure that this bank only got paid if El Paso adopted the strategic option of selling to Kinder Morgan. In other words, the conflict-cleansing bank only got paid if the option Goldman’s financial incentives gave it a reason to prefer was the one chosen.

Defendants argued that Goldman had been sufficiently walled off from the merger negotiation process. The court, however, disagreed, describing the Chinese wall as "not effective."  The role of Goldman in the strategic alternative was viewed as "important" because of the board's need to undertake a relative comparison of the proposed acquisition and the proposed spin off.  Moreover, the court noted "questionable aspects to Goldman’s valuation of the spin-off".  As the court reasoned:

At this stage, I am unwilling to view Goldman as exemplifying an Emersonian non-foolishly inconsistent approach to greed, one that involves seeking lucre in a conflicted situation while simultaneously putting the chance for greater lucre out of its “collective” mind. At this stage, I cannot readily accept the notion that Goldman would not seek to maximize the value of its multi-billion dollar investment in Kinder Morgan at the expense of El Paso, but, at the same time, be so keen on obtaining an investment banking fee in the tens of millions.

The shareholders also alleged that the CEO of El Paso had a conflict of interest.  The CEO was responsible for negotiating with Kinder Morgan.  He allegedly wanted to participate in the acquisition of the E&P business once Kinder had acquired El Paso.  The interest was not disclosed to the El Paso board.  As the opinion described:

[The CEO] kept that motive secret, negotiated the Merger, and then approached Kinder Morgan’s CEO on two occasions to try to interest him in the idea. In other words, when El Paso’s CEO was supposed to be getting the maximum price from Kinder Morgan, he actually had an interest in not doing that.

Once the merger price was set, the CEO allegedly approached Kinder about a possible management bid for the E&P business.  Thus, the CEO, while having a duty to "squeeze the last drop of the lemon out for El Paso’s stockholders," had an alleged desire to purchase the E&P business, something that provided "a motive to keep juice in the lemon that he could use to make a financial Collins for himself and his fellow managers interested in pursuing an MBO of the E&P business."

Efforts by defendants to minimize the CEO's potential conflict were not, at the pleading stage, convincing to the court.  While conceding that a trial may show that the CEO was " the type of person who entertains and then dismisses multi-billion dollar transactions at whim," the court suggested that the facts alleged left open the possibility that the CEO:

did not tell anyone but his management confreres that he was contemplating an MBO because he knew that would have posed all kinds of questions about the negotiations with Kinder Morgan and how they were to be conducted. Thus, he decided to keep quiet about it and approach his negotiating counterpart Rich Kinder late in the process – after the basic deal terms were set – to maximize the chance that Kinder would be receptive.

As a result, the court concluded that, at the pleading stage, shareholders had sufficiently alleged a conflict of interest.  

Primary materials in this case, including the opinion, can be found at the DU Corporate Governance web site.